Hybrid mutual funds are gaining popularity among investors thanks to the convenience they are advertised to provide in terms of holding instruments across most major asset classes (most commonly equity and debt) within a single product. So on the face of it, they a number of advantages to investors. Firstly, since hybrid mutual funds hold instruments across major asset classes, it is widely propagated that they take care of the asset allocation needs of investors to a certain extent. Also, hybrid mutual funds are rebalanced at regular intervals by the managers of such funds. This is done as prescribed mandate of a particular fund. This apparently means that investors may not have to rebalance their portfolios regularly.
These perceived benefits may encourage investors to build a portfolio of hybrid mutual funds for various financial goals, and do nothing after that. But a deeper investigation into the way these funds work would reveal facts that are totally different to what is advertised about these funds. Therefore, in today’s post I’m going to delve deeper into the subject of investing in hybrid mutual funds and try and give a true and fair view of the way they work.
When talking about hybrid mutual funds, there are various categories of hybrid funds available to investors. Let us first look at each of the categories in reasonable detail. The typical hybrid mutual fund comes with variants such as conservative, moderately aggressive and aggressive to cater to the risk profile of each individual investor. The most popular variant among investors is the aggressive hybrid fund, since it provides significant exposure to equity with reasonable exposure to fixed income instruments. And of course, these funds are regularly rebalanced as per the mandate of the concerned fund (typically once a month). This makes aggressive hybrid funds an ideal candidate for long term goals that investors may have. The typical aggressive hybrid fund tends to have an allocation of around 65% to equity. This allows the fund to be taxed as an equity oriented fund. This means the holding period for Long Term Capital Gains (LTCG) would be 1 year, with gains above Rs 1 lakh in a given financial year being taxed at the rate of 10%. This is definitely favourable for investors as far as tax efficiency is concerned. But from the perspective of investment risk, it means that the risk associated with an aggressive hybrid fund is only slightly lower than say a diversified equity fund.
The next category of hybrid mutual funds that deserves attention is the Balanced Advantage Fund. The peculiar feature of this category of mutual funds is that they rebalance the split between equity and debt within the fund on a real time basis for better alignment with prevailing market conditions at a given point of time. In other words, these funds run with a high allocation to equity when the stock markets are doing well, and increase allocation to debt during a phase of downward movement or stagnantion in the markets. This gives investors a better chance of earning optimal returns, regardless of what the markets are doing.
But the interesting thing to note here is that balanced advantage funds tend to maintain a significant allocation to equity (usually around 65%) at all times, regardless of market conditions.
When markets are running high, these funds meet their equity allocation through direct stocks. When the markets are not in the best of health, these funds shift out of stocks and instead opt for equity derivatives as a measure to counteract the increased risk involved in the cash segment of the equity markets. This would allow such funds to enjoy the tax status of an equity oriented fund. But though the mode of exposure to equity changes in order to manage risk, the overall exposure to equity as an asset class remains the same. Also, because such funds are rebalanced on a real time basis the criteria for rebalancing is based on tactical calls taken by the concerned fund managers. If those tactical calls were to go wrong, the resultant risk would have to be borne by the investors themselves. For example, if a fund has a 70% allocation to equity during a bull market, and there is a sudden crash of say 30% in the equity markets, there would be a similar drop in the market value (also known as Net Asset Value or NAV) of the fund, meaning investor returns would be impaired. So effectively, once again there would be no significant reduction in investment risk for investors.
Let us now come to the final category of hybrid mutual funds, namely Multi Asset Funds. These are a special category of funds which are obligated to maintain an allocation of at least 10% to a minimum of three different asset classes by the mandate of such funds. So investors in these funds automatically gain exposure to all the asset classes that the fund holds.
But even so, in order to ensure tax efficiency most multi asset funds maintain a significant allocation to equity while adhering to the minimum exposure limit across asset classes as prescribed by the mandate. Also, this category of funds was introduced to investors in India as recently as late 2018. So these funds do not have a historical track record that is long enough for investors to be able to take away Insights of any note with regard to the performance, volatility and returns associated with such funds. There may be some multi asset funds which stay true to the essence of a multi asset fund and maintain near equal allocation across various asset classes held within the fund. So such funds would do a better job in terms of managing investment risk. But in such a case, the fund would be taxed as a debt fund meaning investors would have to wait for 3 years in order to enjoy long term capital gains and the associated tax benefits.
Therefore, though hybrid mutual funds claim to take care of the asset allocation needs of investors, they don't quite achieve the advertised objective in the true sense. This is because most hybrid mutual funds have a lopsided sided exposure to equity with minimal exposure to other asset classes. That just leaves the question of the relevance of the need to rebalance investment portfolios that consist of hybrid mutual funds. There is a case to be made against rebalancing portfolios with hybrid funds, since the managers of such funds carry out rebalancing within the fund at regular intervals. But, the essential reason why investors need to rebalance their portfolios regularly is to manage risk within the portfolio at the asset class level. And given that most categories of hybrid mutual funds run with significant exposure to equity at all times, not rebalancing portfolios that contain hybrid mutual funds would heighten portfolio risk over time. Therefore, it is best for those who invest in hybrid mutual funds, balanced advantage funds or multi asset funds to treat such funds as pure equity funds and rebalance their portfolios at regular intervals regardless of the rebalancing carried out by the managers of the concerned hybrid funds.
The objective of this article is not to say that hybrid mutual funds are not worth investing in. Hybrid mutual funds definitely have a role to play in investment portfolios if used as part of a wider financial plan, especially to provide for financial goals which are 10 or more years away from falling due. But, it is definitely essential to have a proper understanding of the way hybrid mutual funds work before investing in them. We cannot just create a portfolio of hybrid funds for all our goals and then do nothing, based on the erroneous assumption that the need for asset allocation and rebalancing are automatically taken care of by such funds. In fact, the amount of prior research and effort required when investing in hybrid mutual funds is no less than that required when investing in any other category of funds. The need to follow a clear asset allocation strategy and rebalance our portfolios regularly also does not go away. And this simply means the truth about investing in hybrid mutual funds is that they offer investors no significant advantages in terms of convenience or reduction and management of investment risk, as compared to other categories of mutual funds. We need to ensure that hybrid funds and the proportion in which we use them are an ideal fit for our financial goals in order to get the best out of them. And that should be the single most important takeaway from this post.
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